Yield Curve Inverts

Chart of the Week for January 6-12, 2006

For the first time since the end of 2002, investors witnessed an inverted yield curve on December 27, 2005, as the yield on the two year note rose above the yield of the ten year note. An inverted yield curve is a byproduct of an interest rate environment in which long-term debt instruments have a lower yield than short-term debt instruments of the same credit quality. Over the last twenty five years, there have only been six periods of yield curve inversions. It is considered somewhat rare, as investors tend to demand higher yields on longer dated bonds to compensate for the higher risk. Short-term rates have risen significantly over the past year as the Federal Reserve has tightened its monetary policy, increasing the federal funds rate. Although long-term rates have gone up as well, short-term debt has been most affected by the rate hikes. The above chart illustrates the yield curve at various dates over the last year. Throughout 2005, the yield curve has increasingly flattened, whereas the yield curve as of December 31, 2004 is considered “normal” by historical standards.

Previous yield curve inversions have typically signaled a slowing economy or the beginnings of a recession; the past four recessions in the United States were preceded by an inverted yield curve. However, there is considerable debate over the meaning of the current curve's shape in today's economic environment characterized by strong growth and relatively low rates of inflation. Some fixed income experts believe the inverted/flat curve suggests the end of rising interest rates, while others believe it reflects foreign buying of Treasuries particularly by Asian countries. It is important to remember that the yield curve is one factor, among many, that serves as a leading indicator as to where the economy is headed. According to Federal Reserve Chairman Alan Greenspan, the curve has lost its ability to signal pending changes in the economy because markets have become so complex. Investors should be wary about placing too much emphasis on the recent inverted curve.

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